US-Japan Income Tax Treaty is a bilateral agreement between the US and Japan that aims to eliminate double taxation and prevent tax evasion on income earned by individuals and businesses in both countries. The treaty is officially called the Convention between the United States of America and Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income. As you may agree, the official name is pretty long and a bit too complicated. To avoid potential confusion, we will refer to it US-Japan Tax Treaty. When referring to both US and Japan, we will use the term contracting states.
Background and History of the US-Japan Tax Treaty
Aside from improving the business climate, the principal purpose of international tax agreements between the US and a foreign country is to reduce or eliminate double taxation, and to prevent tax evasion. The US-Japan Tax Treaty is no exception.
This treaty has a long history of evolution as one of the first international tax treaties that the US ever signed. It has undergone several updates and amendments over the years to reflect changes in tax laws and economic conditions in both countries. The first version of the treaty was signed back in 1954 and was followed by updated versions in 1972 and 2003. The most recent amending protocol was signed by both governments on January 24, 2013.
While Japan ratified the Protocol in 2013, it was ratified by the US almost six years later, in July 2019. This amended protocol introduced a number of changes to the treaty:
● General withholding tax exemption for interest and a broader withholding tax exemption for certain dividends
● The introduction of mandatory binding arbitration under the mutual agreement procedure (MAP).
● Reinforcement of Assistance in the Collection of Taxes.
Each Contracting State has an obligation to notify each other of any substantial changes in their tax laws, or any changes that affect their obligations under the applicable Treaty.
Key points & benefits of the US-Japan Tax Treaty
The amended Japan-US tax treaty entered into force in 2019, after Japan and the US officially exchanged instruments of ratification. The treaty provides several benefits for individuals and businesses in both countries:
- The crucial advantage offered by this agreement is the elimination of double taxation. The treaty addresses this issue by allocating the right to tax specific types of income to either the United States or Japan. In other words, it helps to ensure that individuals and businesses are not unfairly penalized by being taxed twice on the same income. For example, the treaty may state that income from business activities will be taxed in the country where the business is based, while income from real estate will be taxed in the country where the property is located.
- The US-Japan tax treaty is providing a level of certainty for businesses and investors by establishing clear rules for determining tax residence and tax rates. This helps to reduce uncertainty and potential disputes, as both Japan and the US have a clear understanding of their respective tax obligations. By providing a predictable tax environment, the treaty can encourage greater cross-border trade and investment.
- The extent of tax exemptions for dividends and interest paid by a country of source (in this instance, the country where the payer resides) has been expanded significantly. We will delve deeper into this topic in the section of the article that covers the Income Tax Provisions of the treaty.
- The amended treaty brought improved dispute resolution procedures and introduced the mutual agreement procedure (MAP). MAP allows for an arbitration system to resolve tax disputes between two countries through a panel of third-party arbitrators. if the competent authorities of Japan and the US cannot solve a tax issue after negotiating for a reasonable amount of time (usually 2 years), they are required to go to arbitration.
- Exchange of information – Facilitating the exchange of information between competent authorities of contracting states to prevent tax evasion. The treaty includes new rules for sharing information and providing administrative assistance between Japan and the US. It aims to help in
the administration of each country’s tax laws and assist in the collection of taxes.
- Expansion of mutual assistance in collecting taxes – The former treaty limited the system for tax collection assistance between contracting states to only cases of abuse of the treaty, but the amended treaty has broadened the scope to include all delinquent tax claims.
The Impact of the US-Japan Tax Treaty on US Expats
One of the key provisions of the US-Japan Tax Treaty is the elimination of double taxation on income earned by US citizens and residents in Japan. This is achieved through a combination of limiting the tax rate on dividends, interest, and royalties to 15% for residents of one country and 20% for residents of the other country and allowing for a tax credit or exemption for taxes paid in the other country.
As a result, US expats in Japan can claim a foreign tax credit on their US tax return for taxes paid to Japan on their Japanese-source income, which can help to reduce or eliminate their US tax liability. This is a significant benefit for US expats, as it helps to ensure that they are not subject to double taxation on the
Income Tax Provisions of the US-Japan Tax Treaty
The US-Japan Tax Treaty includes several provisions that are designed to prevent double taxation of income earned by individuals and businesses in both countries. For example, the treaty includes a provision that allows a credit for taxes paid to Japan on income earned in Japan, which can be used to offset the tax liability in the United States. Similarly, the treaty includes a provision that allows a credit for taxes paid to the United States on income earned in the United States, which can be used to offset the tax liability in Japan.
The treaty also includes provisions that govern the taxation of specific types of income, such as business income, capital gains, and dividends. For example, the treaty includes a provision that allows for a reduced rate of withholding tax on dividends paid by a Japanese company to a US company. Generally, the extent of tax exemptions for dividends and interest paid by a country of source (in this instance, the country of residence) has been expanded. Additionally, stricter limits have been imposed on the tax rates that can be levied by the source country, as outlined below.
|The ownership threshold for exemption from source country taxation is “more than 50%.”||The ownership threshold for exemption from source country taxation is “at least 50%.”|
|Holding period threshold for exemption from source country taxation is 12 months.||Holding period threshold for exemption from source country taxation is 6 months.|
Article 11 defines interest fairly broadly to include income from debt claims of every kind. Under the former treaty, interest was subject to tax by a source country, provided that such taxation did not exceed 10% of the gross amount of the interest. With the amended treaty, all interest is now exempt from tax in the source country, aside from contingent interest.
|Source country taxation of interest is 10% (0% if paid to specified persons, like government bodies and financial institutions)||Source country taxation of interest is 0%, (except for contingent interest)|
Contingent interest is a type of interest that depends on factors such as income, sales, property value changes, receipts, or dividend payments made by the debtor or a related party. Under the amended treaty, the country where the interest arises (the source country) can impose a tax on this type of interest. But, if
the recipient of the interest is a resident of the other treaty country, the source country’s tax cannot be higher than 10%.
Capital Gains Tax Provisions
The Japan-US Tax Treaty includes several provisions that are designed to prevent double taxation of capital gains earned by individuals and businesses in both countries. For example, the treaty includes a provision that allows a credit for taxes paid to Japan on capital gains earned in Japan, which can be used to offset the tax liability in the United States. Similarly, the treaty includes a provision that allows a credit for taxes paid to the United States on capital gains earned in the United States, which can be used to offset the tax liability in Japan.
The treaty also includes provisions that govern the taxation of specific types of capital gains, such as gains from the sale of real estate and gains from the sale of shares in a company. For instance, the treaty allows for a reduced rate of withholding tax on capital gains from the sale of shares in a Japanese company by a US resident.
Capital gains from real property
|Source country taxation applies to capital gains from the alienation of:||Source country taxation applies to capital gain from the alienation of:|
Overall, the treaty expands Japan’s ability to tax capital gains derived from indirect ownership of real property and more closely aligns the treaty language with Japanese and US domestic tax laws.
Are there any specific provisions in the treaty that pertain to US expats working in Japan?
Yes, the US-Japan Tax Treaty contains specific provisions that can benefit American expats in Japan.
Under Article 15 of the treaty, wages, salaries, and other similar remuneration derived by a resident of the United States in respect of an employment shall be taxable only in the United States, unless the employee
is present in Japan for 183 days or more in a 12-month period. If the employee is present in Japan for this time period, the wages, salaries, and other similar remuneration may be taxed in Japan.
Article 16 of the treaty also provides for a reduced withholding tax rate of 15% on certain types of dependent personal services, such as directors’ fees and consulting fees, if the recipient is a resident of the United States. This can help to reduce the overall tax burden for US expats working in Japan and
receiving such types of income.
It’s important to note that the treaty provisions must be interpreted in accordance with the domestic laws of each country, so it’s advisable to consult with a tax professional who is familiar with the treaty and with experience in international tax matters to ensure compliance with all relevant tax laws and regulations.
What is the Saving Clause in US-Japan Tax Treaty?
The saving clause is generally added to tax treaties to restrict their applicability to certain residents/citizens. The saving clause enables each country to continue taxing certain citizens and residents based on their general tax principles in their respective countries. So even though the treaty provides benefits for reducing taxes, each country can still tax as they normally would according to their own laws.
The fourth paragraph of article one in the US-Japan Tax Treaty mentions the Saving Clause that aims to prevent a citizen or resident of the United States from using the provisions of the treaty in order to avoid taxation of US source income. Although the saving clause brings potential restrictions and limitations on benefits, there is an exception to the Saving Clause in the next paragraph (Article 1, Paragraph 5). The exception states that the treaty rules should take priority over any other non-treaty laws. ensuring that the treaty benefits still apply.
What is a Permanent Establishment?
A permanent establishment encompasses various types of business establishments, including a place of management, a branch, an office, a factory, or a workshop. It also includes locations for extracting natural resources (such as a mine, oil, or gas well).
The Permanent Establishment (PE) rules describe a source country’s right to tax income generated within its borders from a business that doesn’t have a permanent establishment in the country of source. For example – if a business from the United States operates in Japan and earns revenue without establishing
a permanent establishment there, Japan’s taxation rights over that income will be restricted.
The Organization for Economic Co-operation and Development (OECD) expanded the definition of permanent establishments in 2018 based on the BEPS Project’s final report. As a result, Japanese law was also revised to include commissionaires/commission agents as part of the permanent establishment. However, the US-Japan Tax Treaty says that a general commission agent is not considered a PE under the treaty. In case of any conflicts between the treaty and Japanese domestic tax law on the subject of PE, the treaty definition takes priority.
Japan-US income tax treaty only affects individuals who are residents in one or both of the contracting states, unless otherwise stated in the agreement. But who qualifies as a resident in Japan? Keep reading to find out.
Tax Residency in Japan
Whether an expat is required to pay taxes on their foreign income depends on their residency status. In comparison to many countries, Japan’s residency guidelines are quite simple. There are 3 categories of residency status:
- Permanent Resident is a Japanese national or an expat who has lived in Japan for at least 5 out of the previous 10 years. Permanent resident taxpayers in Japan are taxed on their worldwide income
- Non-Permanent Resident is an expat who has lived in Japan for a minimum of 1 year but less than 5 out of the previous 10 years. Non-permanent residents in Japan are taxed on their Japanese-sourced income, as well as for foreign income paid in Japan or sent to Japan.
- Non-resident is someone who doesn’t fall into either of the above categories. US expats living or working temporarily in Japan will generally be considered non-residents for tax purposes if they don’t meet the standard of residency. Non-resident taxpayers are taxed only on their Japan-sourced income.
Taxes for expats in Japan
The US-Japan Tax Treaty covers several types of income taxes for both countries. On the US side, it covers the Federal income taxes imposed by the Internal Revenue Code (IRC ) but excludes social security taxes. When it comes to Japanese taxation, the treaty covers the Japanese income tax and corporate taxes.
Aside from the income tax, expats in Japan should be aware of other types of Japanese taxes. A good example is the inhabitant tax. All people who live in Japan pay the inhabitant tax to local municipalities and prefectures. This tax is typically calculated at a rate of 10% of one’s taxable income, but it can vary from one municipality to another. Non-residents will only pay the inhabitants’ tax if they are owners of the property or Japanese companies.
The Japanese gift tax works similarly to the gift taxes in the United States. The recipient pays the gift tax while the donor is exempt from tax obligations. In the case of non-residents, gift taxes only apply in relation to property located within Japan. Expats living in Japan will also need to pay Japanese taxes on all forms of compensation, including non-cash compensations (like relocation expenses, housing stipends, club memberships, and commuting costs).
US-Japan Totalization Agreement
Japan has a well-established social security system. Some expats may have to pay Japanese Social Security taxes, while others will keep paying into the US Social Security system. This is determined by a separate agreement called US-Japan Totalization Agreement.
Totalization Agreement is designed to prevent double taxation of income with respect to Social Security taxes:
● If a US company assigns you to work in Japan for less than 5 years, you will typically pay into US Social Security
● If the assignment exceeds 5 years, you will pay into the Japanese Social Security
● If you are working for a non-US employer in Japan, you will always be subject to Japanese taxation when it comes to social security
● If you are self-employed, you will pay into the social security system of whichever country you live in for more days during the tax year
Overall, the United States has concluded 26 Totalization Agreements (including the one with Japan) that must be taken into account when determining if:
● any alien is subject to US Social Security/Medicare tax
● any US citizen or resident alien is subject to taxation of income with respect to social security taxes in another country
International reporting to IRS
As a US expat in Japan, you may be required to submit tax forms to both Japanese and US governments. Finally, let’s examine some of the most frequently used forms by each country.
Common international US tax forms for US Expats:
● FBAR (FinCEN 114) is used to report Foreign Financial Accounts. If you have a total of at least $10,000 in one or multiple foreign (non-US) bank accounts, then you most likely have to file the form.
● Form 8938 – The US requires foreign asset reporting with IRS Form 8938 (FATCA report) if assets
exceed a certain threshold. The threshold varies based on filing status and residency. Complete
the form and attach it to your Form 1040 when filing taxes.
● Form 3520 must be submitted if an individual receives a gift or inheritance, or when they need to
report certain transactions with foreign trusts.
● Form 5471 is used by individuals who are United States citizens or resident aliens that are
officers, directors, or shareholders in certain foreign corporations.
Japanese Tax Forms for Expats
● Form A – the individual income tax return in Japan, comparable to America’s IRS Form 1040. Something to have in mind is that Japan’s National Tax Agency (NTA) rarely grants extensions. If you exit Japan before the end of the tax year, you will need to file Form A before you leave the country.
● Form B – As an American living in Japan, if you possess assets that generate income such as real estate, investments, or have a business operation, you will need to complete Form B. This form must be submitted along with Form A.
● Report of Foreign Assets – If you meet the criteria for permanent residence in Japan and possess foreign assets worth over 50 million JPY, you must submit a Report of Foreign Assets. Americans living in Japan who need help with Japanese taxes, FBARs, FATCA, or any other international tax issue should consider seeking assistance from tax professionals who specialize in international tax services.